Monday, December 26, 2011

Ricardian Equivalence Redux

I just read Paul Krugman's most recent blog post. This is typical. Krugman is repeating an argument he has been making for a long time. He wants you to think that he has it right, and that there are some "freshwater" (whatever that is) bad people out there who have it all wrong. How could they be so stupid?

Krugman tries to pick on Lucas in his blog post, as "betraying a complete misunderstanding of his own doctrine," and quotes this, which comes from a panel discussion at a conference:

If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. We don’t need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that’s stimulating is the monetary part.

…

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. There’s no reason to expect any stimulation. And, in some sense, there’s nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.

I don't agree with everything Lucas said in that quote, but I think I can safely say that I know Lucas better than Krugman does. I think I understand what ideas he is attached to, and there is nothing in the quote that is inconsistent with those ideas. Further, for something pulled out of an off-the-cuff panel discussion, it's reasonably coherent.

Lucas of course was a primary force behind the revolution in macroeconomic thought that occurred post-1970. But he is also very much an old-school Milton Friedman quantity theorist - an Old Monetarist if you like. That's what is behind the first part of the quote. He's thinking that it's monetary policy that is important, and that monetary policy effects will drive the effects of the stimulus. You may think that's wrong, but that's part of what he thinks.

In the latter part of the quote he has a particular view of the effects of the spending package put in place in 2008. Supposing it is funded by taxation - current or deferred - he thinks it doesn't matter much. Now, even in the context of non-Keynesian macroeconomics, there are reasons why government spending can matter. There are wealth effects; public spending and private consumption might be complementary; a recession may be a good time for public investment in infrastructure. Maybe in the context of the 2008 spending package, Lucas thinks that those things do not matter so much. Maybe he thinks that the planned spending was not thought through very well, and we are better off without it. In any event, I don't see anything in the quote that we would want to condemn Lucas for. The weird part of this is that Krugman is picking on Lucas over Ricardian equivalance. The only piece of the quote that relates to that is the last part: "And then taxing them later isn't going to help, we know that." That's just stating the Ricardian equivalence proposition, which is that the timing of taxation does not matter. Tax me now; tax me later; it does not make any difference. Lucas certainly isn't getting anything wrong.

Next, Krugman wants you to think, not only that Lucas is confused, but that he's somehow besmirching Christina Romer. If you read the quote, Lucas is not saying anything bad about Romer, he's just thinking about the realities of government. In my opinion, Christina Romer deserves besmirching, but all Lucas is saying is that, likely, Romer was not driving the policy, and that her job was to defend it, which is what she did.

Here's the really funny part of Krugman's post:

I’ve tried to explain why Lucas and those with similar views are all wrong several times, for example here. But it just occurred to me that there may be an even more intuitive way to see just how wrong this is: think about what happens when a family buys a house with a 30-year mortgage.

Suppose that the family takes out a $100,000 home loan (I know, it’s hard to find houses that cheap, but I just want a round number). If the house is newly built, that’s $100,000 of spending that takes place in the economy. But the family has also taken on debt, and will presumably spend less because it knows that it has to pay off that debt.

But the debt won’t be paid off all at once — and there’s no reason to expect the family to cut its spending right now by $100,000. Its annual mortgage payment will be something like $6,000, so maybe you would expect a fall in spending by $6000; that offsets only a small fraction of the debt-financed purchase.

Now notice that this family is very much like the representative household in a Ricardian equivalence economy, reacting to a deficit financed infrastructure project like Lucas’s bridge; in this case the household really does know that today’s spending will reduce its future disposable income. And even so, its reaction involves very little offset to the initial spending.

How could anyone who thought about this for even a minute — let alone someone with an economics training — get this wrong? And yet as far as I can tell almost everyone on the freshwater side of this divide did get it wrong, and has yet to acknowledge the error.

Apparently that is supposed to be an "intuitive" way to think about Ricardian equivalence. This is an excellent illustration of Krugman's confusion. The example actually tells you nothing about Ricardian equivalance, or anything remotely related to the effects of government actions on the behavior of private economic agents.

What's going on? In Krugman's example, a family takes out a $100,000 mortgage loan to purchase a house. This family now has $100,000 in debt, and someone else in the economy has a $100,000 asset. What is happening in the aggregate? If this is a new house, then the private sector collectively is foregoing current consumption, and investing in a house which will provide a future stream of consumption. If it's an existing house, then this could be a wash. For example, suppose that the family that sold the house takes the $100,000 it receives from the sale and puts it in a bank that makes the mortgage loan to the family that buys the house. Where is the Ricardian equivalence lesson in all that?

Ultimately, Krugman should be able to do better than this. We're accustomed to his nasty side, but at least he could provide some useful instruction.

45 comments:

I sort of visit your blog to learn more about economics and the only thing I read are huge rants against Krugman in every second post. That can't be healthy. Yes, he called you a bad economist. Maybe he's right, maybe not. But for crying out loud, get over it.

I don't think you understand what a rant is. Further, Krugman never called me a bad economist. If he had, I would feel like I was in excellent company. Mostly Krugman ignores me, or accuses me of "pulling rank," whatever that means. Nothing to get over here, I think. Just adding to the discussion. Maybe you have something to say about economics?

Of course, we now have Keen and Minsky (now there was a real teacher from Wash U) who improve on Krugman, proving there is no Ricardian equivalence

1) if the gov't borrows the money from a bank, there is neither crowding out or a ricardian equivalence. The money supply expands and that expansion permits growth. Savers still have their savings, etc.

2) if the home buyers borrower their $100K from bank, by which the money supply is expanded . . .

I simply do not understand what CL and the anonymous poster have against you critiquing the economic claims made by an influential blogger.

CL -- where is the "rant" here? What in heaven's name are you talking about? Steve lays out the reasons he believes that it is Krugman who does not understand RE. I want to hear what Steve has to say on this. If you don't, then tune out. Or at least sign your name when you want to rant here.

“In Krugman's example, a family takes out a $100,000 mortgage loan to purchase a house. This family now has $100,000 in debt, and someone else in the economy has a $100,000 asset. What is happening in the aggregate? If this is a new house, then the private sector collectively is foregoing current consumption, and investing in a house which will provide a future stream of consumption.”

I don’t see the logic leading up to the proposition that “the private sector collectively is foregoing current consumption.” Granted, the borrower is apt to reduce his consumption spending in order to make his mortgage payments, but, as Krugman points out, these payments will only amount to about $6,000/year.

And it isn’t obvious, to me at least, why the lender who acquires the $100k asset must reduce her consumption by an equivalent amount. Suppose the lender makes the loan using $100k she has locked up in her safe, or by selling $100k in foreign equities, or by liquidating$100k in T-Bills, or by offering the homebuyer an owner-financed loan -- why would any of these transactions necessarily require “foregoing current consumption” in an amount equal to $100k or thereabouts?

Even in the more common case of a simple mortgage loan from a bank, is it necessarily the case that total bank lending remains constant, bearing in mind that some of the $100k spent to build the new home will end up as deposits in other banks?

p.s. David, I'm with you on the unfortunate recourse to anonymity when making certain kinds of comments. In baseball's National League, where pitchers must also bat, there are a lot fewer bean balls thrown than in the American League where they don't.

I have been reading your blog in ever greater depth and concern. It seems to me that, especially for someone who works for a Federal Reserve Bank, that there are a number of fundamentals in need of correction.

We shall try one each day, for a while.

Forty years ago then Senior Vice President Alan Holmes, Federal Reserve Bank of New York stated that the idea of Monetarist policy of controlling inflation by controlling the growth of Base Money failed, saying that it was(page 73):

a naive assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves.

I am a trial lawyer by education and 40 years of training. While there is a great deal bad about the law and lawyers, we do have one thing that is good--our judges act as gate keepers and bar incompetent experts from testifying. And, albeit too infrequently, we pitch incompetents out.

Lucas, is so impeached by his own statements that no judge would permit him to testify and yet we have a blog here that pays attention to him

The reader, and hopefully your students, are taught this about Lucas. In his address as President of the American Economics Association in 2003 he said (not extemp)

"Macroeconomics was born as a distinct field in the 1940's, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of deprssion prevention has been solved, for all practical purposes, and has in fact been solved for many decades.

Now, let's been blunt. Lucas is a arrogant SOB who is wrong, about everything. He hever even saw the Lesser Depression coming, he had no idea how to prevent such, he doesn't know what caused it, and he sure as hell has no idea what to do about it (for such would require him to repudiate everything he has said and written in a lifetime, and he is not about to admit that he was wrong).

Alan Greenspan was wrong, about everything, according to Lucas (the train left the track on his watch). Any yet Robert Taylor just had Greenspan out presenting for Heritgage.

If Lucas (or you) has any moral courage, instead of being after Krugman (playing to your base) you would be after Greenspan and Taylor for letting him talk.

To be clear, Robert Taylo was wrong, about everything.

Do you teach to your students that they are wrong(and that you were wrong)?

One of the reasons I come here is to learn the counter-arguments to the things Krugman writes. It’s an important service for those of us who are trying to better understand economics rather than simply validate our political biases.

In that regard, I think it is important to address the whole of Krugman’s argument. In the case of RE, he’s starting from the perspective that demand is inadequate to achieve full employment. He’s then arguing against the claim that RE completely nullifies the impact of government spending/borrowing by demonstrating that $100K in government spending should not result in a concurrent $100K decline in private sector spending.

The foregone consumption is just national income accounting. Investment, including residential investment, is indeed foregone consumption.

"As regards anonymity, this blog is not academic, it is political."

Where did you get that idea? And what would my political stance be?

Daily question,

"a naive assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves."

You're way off topic here, but I'll give this a try. I interpret the first sentence as saying that the money multiplier stories that people are told in money and banking class are wrongheaded. If that's what he meant, then I agree. Then he says that we have to think about the financial intermediation process, which again is fine. But what does he mean by "look for the reserves?" Actually the way the US banking system works now, you have to think more carefully about what the reserves are doing. In normal times, it's not even useful to think of reserve requirements as binding any more, and you have to take seriously what is going on with intraday payments and how the reserves are used in that process. Currently, there is such a huge stock of reserves that these reserves look pretty much like Treasury bills, except they are actually less useful, from a financial transactions point of view. I have written about this elsewhere.

5 am anonymous,

I have known some very arrogant people, but Lucas is not one of them. I have learned many things from Lucas. Early on, what I learned was economics, from reading his work. When we got to each other better, I learned a lot of other stuff from him. He's basically a fine human being, and I would go to bat for him any day. You don't know what you're talking about.

"He’s then arguing against the claim that RE completely nullifies the impact of government spending/borrowing by demonstrating that $100K in government spending should not result in a concurrent $100K decline in private sector spending."

1. Lucas isn't arguing that RE is critical for nullifying the effect. That only enters into his argument tangentially.

2. If you're going to argue that a departure from RE is important for the effects, you have to coherently argue where RE fails. That's important.

3. As I stated above, there are good reasons why government spending can matter. But it will matter in very different ways depending on what you spend on. And just spending on anything need not be a good idea, no matter the state of the economy.

Professor, "The Central Problem of Depression Prevention Has Been Solved," Williamson

Do you have no shame? Maybe he is nice to his children, dog or cats, but you should be leading the pack to run Lucas out of the profession (and asking yourself, in how many other ways was Lucas wrong?)

Have you ever admitted, in public, being wrong about any issue in economics.

For starters, can you type: Lucas was wrong?

Or, are you going to defend him to the bitter end (and the end is going to be bitter)for your unstated political agenda?

"Or, are you going to defend him to the bitter end (and the end is going to be bitter)for your unstated political agenda?"

Sometimes I disagree with Lucas, and I'm quite happy to do it to his face. He really doesn't mind. Honestly, I don't have a political agenda here, and as Sargent said recently, we certainly don't bring politics into the seminar room.

"Isn't it more than an little disingenuous on your part to say you don't know what a New York Fed Vice President means ..."

No, it's actually not easy to figure out what he is trying to get across. That paper was written in 1969. A lot has happened since then, both in economic thought and in the world. Why would you think what he said then is important?

"The foregone consumption is just national income accounting. Investment, including residential investment, is indeed foregone consumption."

Do you mean Y=C+I, so that if I increases, C must decrease? I think the issue is whether Y is fixed. If it's not fixed, then an increase in I need not reduce C. It could even increase C. But you know that.

p.s. It was someone else who wrote, "As regards anonymity, this blog is not academic, it is political."

Yes, exactly. It's not fixed. This is why the example is confusing. It's a story about a decision by an individual household. It's not informative about what is going on at the aggregate level. To think about the issue, we have to start with the government action. The government is going to spend more on something. What is it spending on? How is the spending going to be financed? Given all that, how do private decisions change in response?

I’m always puzzled by Krugman’s serial explanations of what Ricardian equivalence means. But count me the same, in respect of just about anything I’ve seen from anybody on the subject. It seems to me that a big part of the explanation problem, in general, is the failure to keep movable parts from moving – parts that only obscure the core meaning of the thing.

“If you have never run across Ricardian equivalence, here's the basic idea. Say the government cuts our taxes today, holding constant present and future government spending on goods and services. The tax cut does not come out of thin air - the government has to finance this by issuing debt. But the debt must be paid off sometime in the future. How? The government must increase future taxes. Consumers, being forward-looking and rational, figure out that their current tax cut is exactly offset (in present value terms) by an increase in their future tax liabilities, and they save all of their tax cut rather than spending it, so they can pay the future taxes. The government is saving less in the present, but the private sector is saving more. Everything nets out, and there is no effect on anything.”

One thing puzzles me, in general:

Compared to the counterfactual, a tax cut creates disposable income where none previously existed. Therefore, at the point of the tax cut, momentarily ex post, the saving to offset the tax cut has already occurred in the form of disposable income. And that saving has already been deployed in the form of bonds that the extra disposable income purchased. Those bonds can be redeemed in future in respect of a future tax liability to pay for the recent tax cut.

In addition to all that, then assess whether or not there are any further effects, apart from that (e.g. stimulus effect or whatever, due to money distribution effects or use of bonds as quasi purchasing power, etc.).

I’ve never seen this point made about simple accounting offset, as sort of preamble to any other possible effect. Do you think it’s valid?

In the simple experiment, you can do all the accounting. The individual that gets the tax cut is thinking that their lifetime wealth did not change, and he or she therefore does not change his or her consumption decisions. But something has to change, because the individual got a tax cut, and their disposable income went up. Their savings increased by the amount of the tax cut, and that increase in savings (by all individuals now) is just enough to purchase the extra debt that the government issued to finance the tax cut. All that happened was that the government saved less and the private sector saved more. Net national saving is unchanged.

When I teach students this, what I tell them is that this is where you have to start. If someone is telling you that the government can cut taxes and increase aggregate output, they are telling you that some assumption at the foundation of the Ricardian equivalence theorem does not hold in practice. You want to know where they think the theorem fails in practice. As I explain in the other post, there are some superficial explanations for the failure of Ricardian equivalence that don't hold up when you think about it carefully. What it comes down to is something quite simple - a general principle. If we want the government to do something, we better think it has some natural advantage over the private sector.

Because the explosion and collapse in private debt caused the Lesser Depression (and the Great Depression) particularly because so much of the debt was fraudulent.

On this see Dugger's presentation at the 2008 NABE convention available for free on CSPAN

Munger (Buffett's partner) has remarked that, psychologically, embezzlement and fraud are terrible for an economy, for we feel good because we think spending is up (when it is really our stolen money) and then we found out our money is gone.

Prince said the same thing. As long as the music plays, we have to dance, hoping for a chair when the music stops.

Knowing they must dance, bankers (and I have 40 years in banking litigation have worked on over 20 major bank failures) loan first and then search for reserves to cover the deposits to fund the loans.

"1. This is too complicated. The average consumer is never going to figure it out. According to this line of argument, consumers will see a tax cut, incorrectly infer that their lifetime wealth has increased, and we can therefore trick them into spending more. Of course, in the future, they will wake up to the notion that their taxes are higher than they would have otherwise been, and that they were too profligate in their spending at an earlier date. This hardly seems like the basis for sound fiscal policy. Like all bad behavioral economics, assuming that the average Joe or Jane is stupid puts you on a slippery slope. Maybe private citizens are so bad at making consumption/savings decisions that someone at the Treasury Department should be making those decisions for them."

Isn't this, though, exactly what happens in practice? You may be correct that forming policy around this idea amounts to "tricking" the public, but it is impossible to believe that this isn't exactly what happens.

I'm a case in point. I have two MBA degrees and worked as a security analyst on Wall Street. Financial modeling is what I do. I built extensive models to determine whether, and how much, I should contribute to my HSA, Monte Carlo simulations on retirement spending, etc, etc. The one thing I've never tried to model, or factor into my financial plans, is federal tax and spending policy. There are just too many variables over too long a time frame to try to take a meaningful swag at it.

If I'm not doing it, and as far as I know none of my financial analyst colleagues have done it, who exactly is? And unless it is almost everyone, it's hard to see how RE really has a meaningful impact.

Is there any evidence that the world behaves this way, or is it just a simplifying assumption?

Now we're getting somewhere. Yes, exactly, "embezzlement and fraud are bad for an economy." Our problems are rooted in lack of regulation, which allowed what is essentially theft to occur. Now, the problem is trying to figure out which part of financial activity is actually socially useful innovation, and which part is theft. From your experience, you know how hard it is to tell the difference.

Brian: This is the leap we have to take in all of economic science. We have models, and we have reality. In the models, we are trying to capture the essential parts of reality that are important for the problems we want to address. Typically, when you learn these things, you start with the simplest case - that's like the case where you show how RE works - then you ask where the theory might go wrong in terms of matching what we know about the world, or in saying something useful. On this one - the RE problem - I think it's far more constructive to work on departures from the basic theory like information problems, problems with enforcement of credit contracts and such, rather than to venture into a world where people are doing things that are stupid given the model world I have constructed. In my experience, that's not going to lead to good government policymaking. The way I make my economic decisions does not on the surface bear much resemblance to what people are doing in my models. But I can use Newtonian physics to tell me, given the force transferred to a baseball, where I should go to catch it. I'm not thinking about Newtonian physics when I catch the ball, but Newtonian physics will do a good job of predicting what I do to catch the ball.

"I can use Newtonian physics to tell me, given the force transferred to a baseball, where I should go to catch it. I'm not thinking about Newtonian physics when I catch the ball, but Newtonian physics will do a good job of predicting what I do to catch the ball. "

So people intuitively understand the implications of an x% increase in the deficit on their future tax burden.

The difference I see between the baseball example and RE is that people are actively trying to figure out how to catch a baseball. They learn, over time, how to do it. But it takes effort and practice.

I'm not aware of anyone who's even trying to understand how federal deficits should impact their current spending plans. Given the recent, unprecedented, increase in deficits, it seems we all should have made conscience changes in our behavior to compensate. I know I haven't. I've never heard anyone else say they have either.

So how well would Newtonian physics predict the actions of someone who's not trying to catch the baseball?

It's interesting that Bewley did that research and wrote the book, but I don't think it amounted to anything. We have some economic models that have proven very useful, in spite of the fact that the decision problems faced by the people who live in the models don't look much like the problems that you and I are solving. What do you mean firms maximize profits treating prices as given? Everyone knows that firms don't maximize profits, and each one of them sets their prices. They don't treat them as given. But a large fraction of economic models that are in wide use, and the ones we teach to students, have profit-maximizing competitive (i.e. price-taking) firms in them. But that's fine. It works well and is a useful abstraction.

It's actually a model to explain the behavior of one guy, Harold Zurcher, who worked for the Madison Wisconsin bus company. The model is a complicated stochastic dynamic programming problem. Harold had no idea that was the problem he was solving. Nevertheless, the fact that the model fits Harold's observed behavior was very instructive.

First, I really surprised you with my comments about fraud, didn't I. I understand this stuff far better than you do.

"From your experience, you know how hard it is to tell the difference."

From my experience, No, it is very easy to tell the difference.

The vast bulk of bad loans I see are due to bankers being lazy. For example, during the run up to the Lesser Depression, bankers did nothing for small business. They would just get an appraisal and lend on the seconds on homes and residences.

There was no value added to the lending. No loan officers who were Consigliere, no networking, nothing. The last bank I saw add value of Silicon Valley Nat'l Bank in 2001. SVB would use its private banking to finder individuals who wanted to put $$$ in deals and work with the companies, not just VC firms.

The other day I saw a small sandwich shop close due to retirement. There were 4 banks w/in 85 yards. Not one loan officer called on the staff about a loan, maybe with a silent partner keeping the business going. Lazy, lazy, lazy.

Go read the first chapters of the books on Goldman Sachs. Walking the Streets of New York with cash and notes in a top hat. Now that was banking.

Any decent regulator could watch what happens in the branches and tell what is going on ASAP.

We should only permit two kinds of loans: signature and non-recourse.

Banks would then be forced to know their customers, know their customer's businesses, and compete on value added to the $$$ they lend. Lending on collateral, esp. guarantees, leads to bankers being really lazy.

"First, I really surprised you with my comments about fraud, didn't I. I understand this stuff far better than you do."

No, no surprise particularly. How do you know what I understand? You don't know me from Adam.

In your line of work, some bad behavior may be easy to see. Get into more sophisticated financial activity, and it gets more difficult. How do we know whether a new financial derivative is somehow making us better off as a society by reallocating risk more appropriately or is simply meant to obscure some activity that is akin to theft? The same for accounting practices. What do we want, a Canadian financial system that is extremely safe, but maybe not so innovative, or a more innovative financial system that gets itself into trouble every 15 or 20 years? What do you think?

"We have some economic models that have proven very useful, in spite of the fact that the decision problems faced by the people who live in the models don't look much like the problems that you and I are solving."

Please don't misunderstand me. I'm not saying that rational expectations or even Ricardian Equivalence are not useful simplifying assumptions. What I'm trying to understand is whether economists who use them in their models actually believe that those assumptions hold true in the real world. It seems like some commentators (who may not be economists) are often confused on the difference.

Meanwhile, a quick look at deficits and personal savings rates from 1960-2010 shows that we saved less as average annual deficits increased. Not what you'd expect in a world where people try to offset their PV share of an increase in deficit spending with higher personal savings.

"What I'm trying to understand is whether economists who use them in their models actually believe that those assumptions hold true in the real world."

A model is not truth. It's a model, which is an abstraction. This is not like calculating where the moon will be tomorrow. It's a much harder problem. An economic model, to be useful has to be simple, and very specific to the problem you are trying to address. If you build a model of the economy that contains all the detail in the actual economy then it is the actual economy and you can't figure it out. It's not an issue of whether the assumptions are "true." The model is going to be wrong on some dimensions. It may not have soccer teams and people with five toes on each foot. You strip away what you judge to be irrelevant for the problem, and put together something that, in this case is going to help you make good policy. One key to that is that the structure in the model is invariant to the policy experiment you are thinking about. You don't see that in the natural sciences, which is important.

"There may be other reasons why it's a bad idea, but RE isn't one of them."

No, RE is actually important to thinking about the "stimulus." For example, if the rationale for the policy is that we want people to spend more, and part of what is going to make them spend more is that we are going to cut their taxes, then we need to be convinced that there is something about the policy that makes RE fail. Of course in the case of the 2008 stimulus, there are a whole set of other issues to think about that are unrelated to RE. Under what conditions does it make a difference if the government spends more on goods and services, and does it matter what it spends on?

"An economic model, to be useful has to be simple, and very specific to the problem you are trying to address."

"For example, if the rationale for the policy is that we want people to spend more, and part of what is going to make them spend more is that we are going to cut their taxes, then we need to be convinced that there is something about the policy that makes RE fail."

So what you're saying is that, for RE to be a useful simplifying assumption, people actually should be saving more when deficits increase. Otherwise, it's not a good predictor of how they will respond to tax cuts.

Imagine a country inhabited by "Keynesian households," that is to say, people who believe that debt-financed public investments undertaken when unemployment is high and interest rates are low will yield higher GDP growth than the status quo.

What happens if we add Ricardian Equivalence? Well, if expected GDP increases, then the government debt can be paid off at a lower tax rate (applied to larger income base). And if expected GDP is higher, then my future income is likely to be higher as well. Thus, these Keynesian households rationally believe their after-tax incomes will be greater. And, if so, then they may actually increase their spending today, giving rise to a Keynesian cum Rational Expectations multiplier.

I'm not unfamiliar with model building, although mine aren't nearly as complex. In my world I may build a financial model of a corporation with certain assumptions. One assumption may be profit margins. That model can be very useful in answering all kinds of questions and testing various sensitivities. One thing the model can't do, though, is tell me anything about profit margins.

What I seem to be hearing from people in the RE debate is that they've built models assuming people react a certain way to deficit spending and then hold up the model results as proof of how the economy responds to deficit spending. But all they've really done is build a complicated way of restating their initial simplifying assumptions.

Add in the fact that people don't really act the way the initial assumption says they should and it's hard to see how we're saying anything useful at all about deficit spending.

You're starting to get it. Everything we do involves some model. There's some abstraction that guides me out the driveway in my car and over to Trader Joe's. That's a two-dimensional map in my head that guides a sequence of actions that I take in the car.

We construct economic models for many different purposes. Sometimes it's just a simple analytical model that we're going to use to teach an idea to students, or to learn something ourselves. Sometimes it's something more complicated - a model that we can run on the computer to give us quantitative answers to policy questions. In those quantitative models, we are still focused on specific questions, and maybe we want to focus our attention on the key "friction" that we think is important. Here's an example. New Keynesians, for example Mike Woodford, think that the key friction in the economy, which leads to a market failure the government should correct, is sticky wages and prices. In a New Keynesian model, most of the action is coming from the sticky wages and prices. Ricardian equivalence holds, and markets are "complete" in the sense that you can insure against essentially anything. Now, you might think it is unrealistic to be assuming Ricardian equivalence, with all these economic agents being so prescient, or that you really can't insure against everything in practice, but a lot of people like those models, including Paul Krugman. Part of this is just a matter of being internally consistent. The model will be really screwed up if you don't have that. You have to have the people in the model behaving in a way that is consistent with the fictional world you put them in.

I think Krugman's missrepresentation of Ricardian Equivalnce shows exactly why models, when used appropriately, can help maintain logical consistency when pondering ideas that are too complex to simply talk about in plain language. If he had struggled through the math in Robert Barro's "Are government bonds net wealth?" paper he would have gotten some important insights on what drives Ricardian Equivalence, and would not have committed the error of suggesting that it matters whether one has to pay back the government transfer all at once or in small amounts over a long horizon.

At the same time, laying out clearly the assumptions on which the Ricardian Equivalence is based has helped many economists identify several reasons why it does not provide a convincing argument that the impact of deficit-financed spending would be as small as that of a tax-financed spending. Here are three: 1) A current increase in infrustructural investment can be offset by a cut in such investment later on, thus preventing a net increase in government spending in the long run. The administrative and other costs of altering taxes to match spending at any point in time will be higher 2) During a recession, especially that severe, people's consumption may be below their optimal path due to liquidity constraints (their inability to borrow against a temporary drop in income because they do not meet the criteria). 3) People are not fully rational. They are not so self-disciplined as to save now in anticipation of higher taxes, especially if the increase is expected far into the future, due to hyperbolic-discounting. According to behavioral studies they also tend to largely ignore uncertain future outcomes until they have enough information.

Actually, here's the excerpt, in case you don't want to read the whole thing:

In my view, irrationality is the great cop-out, and simply represents a failure of imagination. Rationality is so weak a requirement that the set of potential explanations for a particular phenomenon that incorporate rationality is boundless. If the phenomenon can be described, and we can find some regularity in it, then it can also be described as the outcome of rational behaviour. Behaviour looks random only when one does not have a theory to make sense of it, and explaining it as the result of rational behaviour is literally what we mean by ‘making sense of what we are seeing’. If we are accustomed to observing people who do not have schizophrenia, we might describe a schizophrenic as ‘irrational’, but for a trained psychiatrist, a schizophrenic behaves in predictable ways. The schizophrenic has his or her own rationality, and hard work by scientists in the field of psychiatry has taught us how to intervene in the lives of people with this mental illness to make them better off.

Dr. Williamson, thanks for the response. I am still debating the issue of rationality internally, and will be for a while I am afraid. A hyperbolic discounter is indeed maximizing an objective function at each point in time, but is that enough to declare his behavior rational, in a more general sense, in the presence of time inconsistency?

Moreover, is the attempt to model any predictable behavior AS IF it is the result of constrained optimization, however weird the objective function may be, better than alternative attempts? Should we model why people may limit the set of possible choices by assuming that they engage in further computations that involve weighing the costs and benefits of further weighing costs and benefits of alternative actions? I can think of at least a few respectable economists, i.e. Richard Nelson, who may not agree.

Anyway, to avoid becoming a troll, since this discussion goes beyond your original post I will end my participation here. I did like your review by the way, and agree with many of the (counter)points you make.

Andolfatto: Um, I did sign with my name, did I not? If Mr Williamson finds Krugman dishonest and bad for the profession, why bother adressing his claims at all? It's just ironic that every post on this blog nowadays is about Krugman, perhaps he should rename the blog to 'Krugman Watch' instead.

Back to the topic, one problem I find with Lucas argument is the existence of economic cycles. It's much easier to pay back a debt during good times when employment, hence the government revenue, is high. Also, it fails to take into account that during the years the debt is being paid back, many new households enter the market. In my opinion the losses of not doing anything about the recession are far greater in terms of lost investments, unemployment, growth and so on, than paying slighly more in taxes for some years in the future.

1. Yes, I know this is tiresome. I got into this in the last few days more or less by accident. I'm working (or trying to) on something else, but when something like this comes up, you have to go for it while it's fresh. Andolfatto and I are self-appointed Krugman police - Mounties if you like - and have to do our duty when the call comes.

2. On the topic: Ricardian equivalence helps to focus attention on what is key to how government policy works, which is the functioning of markets for credit and insurance. Giving you a tax cut today and taxing you in the future is like giving you a loan, for example. You're thinking about the right things, but the questions are hard for us as economists to answer. A tax cut seems like a blunt tool to use if the problem is that some segment of the credit market is not working efficently. Why shouldn't the government direct credit to particular people instead. Why isn't unemployment insurance a sufficient tool to relax credit constraints? Speaking of unemployment insurance, could we improve those programs?